Data to Virtue

"Wisdom is to know what to do next; virtue is doing it." -- David Starr Jordan, American Naturalist -- Observation collects data from which we build knowledge. Wisdom makes sense of that knowledge. However, it is not enough to merely develop wisdom, we must act on what we know. That is virtue--and the purpose of this blog--from data to virtue.

Tuesday, March 21, 2006

Laughable Laffer Legacy

Back in the 1980's, it was popular with politicians (particularly Republicans) to refer to the Laffer Curve to paint a picture that if taxes where lowered, tax revenues would go up. This curve is represented below. It graphically displays what is intuitively obvious; there is some maximum federal income (revenue) between the two boundary conditions. If the tax rate is zero, revenues are zero. If the tax rate is 100%, nobody will bother
working entirely for the government, and revenues are again zero. Where that maximum falls however, is likely well beyond 50% (you can read more about this here

The problem with these discussions were there was never any data presented. People that wanted to lower taxes believed we were on the right side of the peak and argued strongly without ever presenting data. No body else cared. The reality is during WWII, when the top brackets were well over 75%, a few wealthy indivuals may have indeed been on the right side of the peak. This, however, is clearly not the case today where the top bracket is 35%, yet I still hear the Laffer curve as having some applicability to today's tax base.

Let's look at the data. In the curve below, I have plotted the change in the per capita revenues collected from one year to the previous year vs. the change in the effective tax rate from one year to the previous year.
Note, the zero-zero point is in the right-center of the figure, not at the lower left-hand side. (Click on the figure to see a larger version.)

The presence of the vast majority data in the upper right and lower left quadrants show that we are clearly on the left half of the peak in the Laffer Curve. In other words, the Laffer Curve does not apply to the modern era!


One can clearly see that every time the effective tax rate was increased, revenues increased (upper right quadrant); just as one would expect if we were on the left half of the peak in the Laffer Curve. Half the time the effective tax rate was lowered, revenues decreased (lower left quadrant); again consistent with being on the left half of the Laffer peak. To be fair, half the time the effective tax rate was lowered, revenues increased (upper left quadrant). However, the few points in the upper left quadrant are due to a significant increase in the economy that overshadowed the loss in revenues from the lower tax rate.

One final note, the three points furthest from the origin in the lower left quadrant are in 2001, 2002, and 2003 where we gave tax breaks to the most wealthy. I discuss the argument that this loss in tax revenues is important to stimulate the economy in my entry on tax rates and revenues: Even if we all agree low taxes are a good thing, then the government can't both decrease it's revenues and increase it's spending. That is not a sustainable tactic.

Don't let anyone tell you the Laffer Curve, that applied after WWII, is still a justification for lowering tax rates today (i.e., to increase tax revenues); it simply isn't true any more. Urge your representatives to establish a tax rate schedule, leave it alone, and focus on more important issues.

The effective tax rate was aggregated across all tax brackets. In other words, it is the total revenues collected from income tax divided by the total taxable income reported; an average tax rate across all tax payers. In simpler terms, the figure shows if the taxes collected, per person, in a given year went up or down from the previous year based on whether the effective tax rate went up or down from the previous year.

These data are from, starting in 1979.


At 7:42 AM, Anonymous Anonymous said...

Are you aware that even democrats believe that if taxes were lowered, revenue would go up? Why do you think they passed a one time stimulus payment of 300-600 dollars for most Americans. Beacuse they knew that this small injection of money would stimulate the economy. So...if more Americans, had more money in their pockets, the economy would do better.....

Now if you don't believe in this. I would tell you, stop asking for a raise at work, stop educating yourself to get a better job, and burn your stimulus check, because apparently, to you, any money back from the goverment in a form of cash back, or tax cut, doesn't work...

At 8:07 AM, Blogger Andrew R. Hanson said...

Anonymous, you seem to have both the laffer curve and this argument confused. The question at hand is whether lowering tax rates will increase tax revenues, not whether tax cuts will spur economic growth. The argument here is that higher tax rates lead to higher revenues unless you're around WWII levels (75%). So, your point is moot.


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